Now that even China’s president has joined the verbal jawboning campaign to inspire confidence in retail investors and get them to buy Chinese stocks, vowing “unwavering” support for the country’s private sector (just so Trump will finally stop pointing to the Shanghai Composite’s bear market as proof the US president is winning the trade war), and following last Friday’s dramatic plunge in Chinese A shares followed by a just as dramatic rebound on Monday (which however fizzled on Tuesday), analysts are finally taking a deep dive inside the risks and perils facing the Chinese stock market, and the biggest danger they find is a ticking 5 trillion pledged share time bomb.

In a note released this morning by Goldman’s Kinger Lau, the China strategist looks at the recent rout (and modest rebound) in China, and compares is to the 2015 bubble and bust cycle.

What he finds is – good news – that the current episode is “less systemic” compared to 2015 because:

Brokers’ margin financing balance has been significantly reduced, from Rmb2.3tn at the peak of June 2015, to around Rmb765bn as of last Friday, representing only 1.8% of listed market cap (3.8% of free-float cap);

Off-balance-sheet (hidden) leverage is less prevalent based on our bottom-up aggregates and channel checks, and the overall leveraged positions in equities are significantly down from 2015;

On the whole, retail investors’ exposures to equities remains low in terms of their asset allocation, with equities accounting for roughly 3% of Chinese households’ balance sheets (vs. 63% for real estate);

But in a key shift, “users of financial leverage in equities have shifted from individuals to major shareholders in the form of Stock Pledged Loans (SPL)” this time around with “the risks revolving around SPLs being the major concerns in this market downturn.”

And yet is this massive stock pledged overhang which precipitated a huge margin call last week, and which we first noted almost half a year ago quite as benign as Goldman would like to make it? Here are the facts:

By aggregating more than 40,000 transactions from WIND, around 5 trillion yuan worth of A-shares have been collateralized for financing (11% of listed market cap with 3,478 A-share companies engaging in SPLs, 98% of total listed companies). That said, CNY5 trillion represents the aggregate notional value of the collateral as brokers (and banks) usually provide 35-40% loan-to-value (LTV) for stock-pledged loans, implying around 2 trillion yuan of outstanding SPLs based on a 40% LTV assumption;

Given the weak market performance YTD, Goldman then estimate that around 1 trillion yuan of SPLs are at margin call/liquidation risk, representing 49% of total loans outstanding, 2% of market cap, with the potential loss on SPLs accounting for 2% of aggregate brokers’ capital

And while the above risks look largely manageable according to Lau, the threat is that the self-reinforcing nature of SPLs (which applies to all kinds of financial leverage) makes this a dynamic risk factor. In this vein, one can assume that if the market falls another 10%/30% from here, largely matching Goldman’s “Bear” and “Crisis” scenarios, 1.2 trillion and 1.7 trillion yuan of the outstanding SPLs would be facing margin call/liquidation risks.

And here Goldman makes a bold assumption, namely that whereas historical data on actual defaults/liquidation is spares, the bank believes that most borrowers facing margin call pressures were able to come up with more collateral (i.e. cash, equity, or even properties) to top-up margin.

Even for those who couldn’t secure additional collateral and stock prices fell below liquidation levels, forced selling by brokers has seldom happened, because:

there are many restrictions on major shareholders disposing shares in China A;

brokers tended not to liquidate the positions as doing so would trigger more selling pressure and deplete the value of other collateralized shares,

brokers don’t want to damage the relationship with their corporate clients; and,

in some cases, regulators gave window guidance to brokers to avoid forced selling.

The above four may well be accurate, and yet the question then emerges: why did precisely the kind of marketwide margin call and subsequent liquidation take place last Thursday…

… when it was, according to Goldman, not supposed to? Would it, perhaps, indicate that borrowers have run out of more collateral to pledged? And if so, just how long until the next major market selloff triggers the remainder of China’s ticking 5 trillion yuan pledged stock time bomb.